Business
R
esearch
VOLUME 8 NUMBER 1 2014
CONTENTS
Types of Restatement Decisions and Ex-Ante Red Flags of Internal Control Quality 1
Ya-Fang Wang & Yu-Ting Huang
Halo Effect in Analytical Procedure: The Impact of Client Proile and Information
Scope
9
Intiyas Utami, Indra Wijaya Kusuma, Gudono & Supriyadi
Brand Management in Small and Medium Enterprise: Evidence from Dubai, UAE 27
Raghava Rao Gundala & Hanin Khawaja
Knowledge Management Adoption and Diffusion Using Structural Equation Modeling 39
Li-Su Huang & Cheng-Po Lai
Southern African Development Community Free Trade Agreement Impact on South
Africa Stock Returns
57
Yvan Nezerwe
The Impact of Signiicant Negative News on Consumer Behavior towards Favorite
Brands
65
Brad Sago & Craig Hinnenkamp
Agency Level Management of Roads Maintenance Levy Fund: Evidence from Kenya 73
Daniel Odongo Oronje, Charles M. Rambo & Paul A. Odundo
Financial Literacy and Retirement Planning: Evidence from Puerto Rico 87
Karen C. Castro-González
Economic Goals Ranking Approach Incomparative Analysis of Economic Systems 99
Alexander Katkov
Government Initiatives toward Entrepreneurship Development in Nigeria 109
Jeff Anstine,
North Central College Michael Godfrey
University of Wisconsin- Oshkosh Giuseppe Galloppo
University of Roma Tor Vergata Jorge Hernandez
Universidad Nacional Autónoma de Mexico Robert Isaac
University of Calgary Petr Marek
University of Economics-Prague Rubén Molina Martínez
Univ. Michoacana de San Nicolás de Hidalgo Elvis Mujacevic
University of Rijeka
Linda Naimi
Purdue University M.T. Naimi
Purdue University Paolo Tenuta
University of Calabria Eduardo E. Sandoval
Universidad de Concepción Erico Wulf
Universidad de la Serena-Chile
Editorial Advisory Board
Editor in Chief
Terrance Jalbert
Managing Editor
Mercedes Jalbert
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1
TYPES OF RESTATEMENT DECISIONS AND EX-ANTE
RED FLAGS OF INTERNAL CONTROL QUALITY
Ya-Fang Wang, Providence University
Yu-Ting Huang, Chung Yuan Christian University
ABSTRACT
We investigate the association between financial restatements and internal controls by examining whether voluntary restatement decisions are associated with internal control quality. We focus on companies’ voluntary restatements because they are more susceptible to the numerous provisions imposed by SOX. Empirical results show that voluntary restatement decisions are associated with internal control deficiencies, particularly when companies of voluntary restatements suffer higher restatement severity. Our findings imply that voluntary restatement decisions may interpret as signals of internal control quality.
JEL: K22, M41, M43, M49
KEYWORDS: Internal Control, Voluntary Restatement
INTRODUCTION
fter a series of corporate scandals, SOX has imposed numerous provisions on weaker internal control quality and misstated financial statements to prevent deceptive accounting practices. For example, the SOX imposed increased responsibility on audit committees (Section 301 and 407) and determined that the primary responsibility of audit committees is to oversee financial controls and assure the quality of financial reporting. Prior studies have found that companies that restate, in general, have weaker corporate governance (Abbott et al. 2004; Farber 2005; Efendi et al. 2007; Agrawal and Chadha 2005), and Srinivasan (2005) documented apenalty for audit committee members in companies, which restate, because restatements were seen as a failure of financial reporting. In the post-SOX period, audit committees are closely associated with internal control quality (Krishnan 2005; Zhang 2007; Hoitash et al. 2009). For example, Hoitash et al. (2009) documented that lower internal control quality was associated with relatively fewer audit committee members with accounting or supervisory experience, and a weaker board committee. Internal control quality has improved since the implementation of Section 404, but few studies have investigated whether and how restatement disclose decisions lead to the detection and correction of ex-ante red flags of internal control severity. We argue that not all restatements are implying question internal controls, because restatement announcements have different meanings (e.g., voluntary disclosure, downward restatement, upward restatement, etc.) and may imply various ex-ante implications on internal control quality. For example, we expect that voluntary disclosure of downward restatements is a red flag of internal control severity. Therefore, this study investigates whether originally restatement decisions are implying ex-ante red flags of internal control quality, particularly following voluntary downward restatements.
Our results provide evidence that not all restatements are implying question internal controls. We find that voluntary restatement decisions are more likely to be associated with higher internal control severity only for companies with downward restatements. Our findings imply that voluntary disclosure of downward restatements is a red flag of internal control severity. Our findings provide important public policy implications to the regulators and policy-makers.This study contributes to three important streams of research. First, this investigation extends previous research into the quality of internal controls by examining different types of restatement decisions and the red flags of internal control environments. Second, this study contributes to the literature on the association between internal control quality and restatement decisions by analyzing different restatement decisions. Finally, this study provides important public policy implications that voluntary disclosure of downward restatements is a red flag of internal control severity. The remainder of this study is organized as follows: Section 2 discusses the previous
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literature most relevant to this study. Section 3 describes the sample selection procedure and research design. Section 4 reports the empirical results and their implications. Conclusions are drawn in Section 5.
LITERATURE REVIEW
After Enron’s bankruptcy, SOX has imposed numerous provisions on misstated financial statements to prevent deceptive accounting practices and, therefore, improve the quality of corporate financial reporting. For example, SOX Section 301 directs the SEC to require audit committees to establish procedures to handle complaints involving “accounting, internal accounting controls, or auditing matters” and to provide confidentiality to employees who submit complaints. The SEC (2003a) further states that the audit committee plays a critical role in providing oversight and serves as a check and balance to a financial reporting system of a company. The audit committee of a company provides independent review and oversight of financial reporting processes, internal controls, and independent auditors.
Furthermore, the SEC (2003b) mandates that all written communications, including “reports on observations and recommendations on internal controls”, between accountants and management be provided to the audit committee. AICPA (2005) also indicates that the primary responsibility of the audit committee is the system of internal control over financial reporting. Indeed, prior studies have indicated that audit committee members accept responsibility for monitoring internal controls (Carcello et al. 2002; Gong et al. 2009; Barua et al. 2010), and that an effective audit committee can directly engage in overseeing company controls by reviewing with the financial and accounting staff the internal accounting procedures and controls (Gong et al. 2009). In short, the role of Section 301 in the internal control structure is to focus on assuring the internal control over financial reporting are in place and operating effectively.Recently, some studies have demonstrated a link between internal control quality and the likelihood of subsequent financial restatements (Hammersley et al.
2008; Li and Wang 2006; Nagarajan and Carey 2008; Plumlee and Yohn 2010). Ashbaugh-Skaife et al. (2007), Grothe et al. (2007a) and Grothe et al. (2007b) have also indicated that companies with material weaknesses frequently find it necessary to restate earnings, and material weaknesses are often disclosed following restatements. In other words, prior research has suggested that high quality internal controls improve the financial reporting process and reduce the likelihood of restatements. As mentioned above, previous studies on the relationship between internal control quality and restatements focus on the consequences of internal control weaknesses. However, prior research ignores the fact that originally restatement announcements have different types and may imply various implications on internal control quality. This raises the question of whether originally restatement announcements are implying ex-ante red flags of internal control quality, particularly following voluntary downward restatements. Thus, this study differs from previous studies in attempting to examine the association between restatement decisions and internal control quality by examining whether originally restatement announcements reveal ex-ante red flags of internal control quality.
RESEARCH DESIGN
This study investigated financial accounting restatements announced between November 2004 and December 2005, using the probit and regression models. This section first details the data sources and selection methods used to generate the research sample. The research model is then introduced, and the test and control variables discussed.
Data and Sample Selection
3 Quality of Internal Control
This study identified internal control weaknesses by searching each SEC file (e.g., 10-K, 10-K/A, etc.) to ensure disclosure of any material weakness in the internal control. Moreover, this study used the search term “did not maintain effective internal control” to identify internal control weaknesses. This term is frequently used in audit reports on internal control over financial reporting. The search covers 10-Ks from November 2004 through December 2005. Prior studies have mostly focused on the existence of control weakness. However, different types of weakness have different effects. Following Ge and McVay (2005), Doyle et al. (2007a) and Doyle et al. (2007b), this study also classified the disclosure of internal control weakness into two types: account-specific material weaknesses and company-level material weaknesses.
Restatement Announcements
This study hand-collected data on the dates of initial restatement announcements from the Lexis-Nexis News Library, which covers all interim and annual restatements announced between November 2004 and December 2005. Identifying precise announcement dates for restatements is challenging. Therefore, this study only considered the first release of the restatement announcement of each company in a given year. Similar to Palmrose et al. (2004) and Kinney et al. (2004), this study used several key words to search for restatements, including “restate,” “restatement,” “revise,” “revision,” “adjust,” and “error.” The event day is determined by the first restatement announcement date identified in the Lexis-Nexis News Library. This study also searched the EDGAR database to double-check the correctness of the event days. Finally, this investigation added restating companies mentioned in other sources discussing restatements, such as the GAO (2006) report, Accounting Today News, BNET Today News, CFO.com News and Compliance Week News.
Others
Company-level accounting data are obtained from the Compustat database. The Compustat database includes not only data from balance sheets, income statements, and cash flow statements, but also industry classifications, and audit opinions for U.S. companies. The database contains most variables of interest.
Model Specification－Internal Control Quality Vs. Determinants Of Voluntary Restatements
We constructed research model of internal control quality to assess whether voluntary restatement decisions are associated with internal control quality. The research model is as follows:
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company-level in following analyses. Account-specific material weaknesses relate to controls over specific account balances or transaction-level processes. Meanwhile, company-level material weaknesses relate to more macro-level controls such as control environment or overall financial reporting process. To understand degree of internal control deficiency, this study also considers company internal control weaknesses disclosured in their Internal Control over Financial Reporting.
RESULTS AND ANALYSIS
Our research sample is composed of 377 U.S. companies that announced restatements between November 2004 and December 2005. Table 1 presents the descriptive statistics for all the variables used in our analyses, partitioned by two distinct groups: voluntary disclosure restatement subsample (n = 216), and non-voluntary disclosure restatement subsample (n = 161). As such, comparing two subsamples provides evidence as to whether voluntary restatement decisions are associated with internal control quality. We find that companies voluntarily announcing restatements are more likely to have weak internal controls, and involve more internal control weaknesses than restating companies of non-voluntary disclosure. Further, we partitioned the voluntary disclosure restatement subsample into two distinct groups: upward restatement subsample (n = 58), and downward restatement subsample (n = 158). As depicted in this Panel B, downward restating companies voluntarily announcing restatements are more likely to have weak internal controls, and involve more internal control weaknesses than upward restating companies voluntarily announcing restatements. In essence, companies voluntarily announcing restatements suffer higher internal control severity in the downward restating subgroup.
Table 1: Descriptive Statistics (N=377)
Panel A：Voluntary and Non- Voluntary Restatement Type Var.
Panel B： Upward and Downward Restatement Type Var.
This table summarizes descriptive statistics for all variables in our regression models. Panel A provides descriptive statistics of voluntary and non-voluntary restatements. Panel B presents descriptive statistics of upward and downward restatements.
5 restatements are associated with internal control deficiencies.
Table 2: Internal Control Weakness and Voluntary Restatement Decision
Model (1) (2) (3)
Var. Total sample Upward Downward Pred. Sign Coef. z-value1 Coef. z-value Coef. z-value
Asterisks *, **, *** indicate significance at the 0.10, 0.05, and 0.01 levels, respectively. One-tailed for directional expectations, two-tailed for others. This table shows the regression estimates of the equation: ICWi,t / ICNi,t = α0 + α1VRESTi,t + α2LOSSi,t + α3DEBTi,t + α4ROAi,t + α5QUICKi,t
+ α6SIZEi,t + α7BIGNi,t + α8GCi,t + α9[Fixed Effects] +εi,t . Table 2 summarizes the regression of internal control weaknesses on voluntary
restatement decisions, and associated control variables. All models include year and industry fixed effects.
Panel A of Table 3 details the type of internal control deficiencies of restatement companies. As depicted in Panel A, restating companies with weak internal control system have the highest percentages of company-level material weaknesses (64.19%).
Table 3: Descriptive Statistics for Internal Control Severity
Panel A：Account-Specific and Company-Level Material Weakness Type
Panel B：Number of Internal Control Weaknesses and Restatement Type
Quantity Upward Voluntary Downward Upward Non- Voluntary Downward Total
1 9(6.08%) 10(6.76%) 4(2.70%) 35(23.65%) 58(39.19%)
This table summarizes descriptive statistics for internal control severity. Panel A provides descriptive statistics of account-specific and company-level material weaknesses. Account-specific material weaknesses relate to controls over specific account balances or transaction-level processes. Company-level material weaknesses relate to more macro-level controls such as control environment or overall financial reporting process. Panel B presents descriptive statistics for number of internal control weaknesses and restatements.
6
restatements are announced voluntarily or non-voluntarily (52.02% and 22.97%, respectively). Overall, these findings suggest that voluntary disclosure of downward restatements are more likely to be associated with higher internal control severity.
Table 4 documents the results of the number of internal control weaknesses regressed on voluntary restatement decisions. Then we further explore the association between internal control deficiencies and voluntary restatement decisions in the upward restatement subsample and downward restatement subsample. The first column shows that the coefficient of VREST is insignificantly positive, and the coefficient of VREST is insignificantly negative in the second column (upward restatement subsample). Further, empirical results show that the coefficient of VREST is significantly positive in the downward restatement subsample (column (3)), suggesting that voluntary disclosure restatements are more likely to be associated with higher internal control severity only for downward restating companies.
Table 4: Internal Control Severity and Voluntary Restatement Decision
Model (1) (2) (3)
Var.
Total sample Upward Downward Pred. Sign Coef. t –value Coef. t -value Coef. T-value
CONSTANT 2.05 2.81*** 3.08 3.09*** 1.21 1.26
VREST ＋/－ 0.22 0.82 -0.30 -0.83 0.51 1.35*
LOSS ＋ 0.82 2.21** 1.53 3.16*** 0.46 0.90
DEBT ＋ 0.42 1.35* 0.15 0.31 0.34 0.86
ROA － -2.35 -2.14** 1.99 1.43* -4.84 -3.27***
QUICK － -0.11 -1.74** -0.10 -1.17 -0.13 -1.58*
SIZE － -0.16 -1.70** -0.16 -1.18 -0.12 -0.99
BIGN － -0.43 -0.89 -1.77 -2.90*** 0.29 0.43
GC ＋ 1.16 4.03*** 0.82 2.16** 1.30 3.38***
Adj. R2 13.41% 16.18% 15.68%
Nobs. 377 125 252
Asterisks *, **, *** indicate significance at the 0.10, 0.05, and 0.01 levels, respectively. One-tailed for directional expectations, two-tailed for others. This table shows the regression estimates of the equation: ICWi,t / ICNi,t = α0 + α1VRESTi,t + α2LOSSi,t + α3DEBTi,t + α4ROAi,t +
α5QUICKi,t + α6SIZEi,t + α7BIGNi,t + α8GCi,t + α9[Fixed Effects] +εi,t . Table 4 summarizes the regression of internal control severity on voluntary
restatement decisions, and associated control variables. All models include year and industry fixed effects.
This study also examines the sensitivity of the reported empirical results by excluding companies of auditor changes, management turnover, and merging. After rerun our research models, this study obtains results similar to those reported in the tables.
CONCLUSIONS
7 REFERENCES
Abbott, L. J., Parker, S., & Park, Y. (2004). Audit committee characteristics and restatements. Auditing: A Journal of Practice and Theory, 23(1), 69-87.
Agrawal, A., & Chadha, S. (2005). Corporate governance and accounting scandals. The Journal of Law & Economics, 48(2), 371-406.
American Institute of CPAs (AICPA). (2005). Internal control: A tool for the audit committee. New York, NY, AICPA.
Ashbaugh-Skaife, H., Collins, D.W., & Kinney, W. R. (2007). The discovery and reporting of internal control deficiencies prior to SOX-mandated audits. Journal of Accounting and Economics, 44(1-2), 166-192.
Barua, A., Rama, D. V., & Sharma, V. J. (2010). Audit committee characteristics and investment in internal auditing. Journal of Accounting & Public Policy,29(5), 503-513.
Carcello, J. V., Hermanson, D. R., Neal, T. L., & Riley, R. A. (2002). Board characteristics and audit fees. Contemporary AccountingResearch, 19(3), 365-384.
Doyle, J., Ge, W., & Mcvay, S. (2007a). Determinants of Weaknesses in Internal Control Over Financial Reporting. Journal of Accounting and Economics, 44(1-2), 193-223.
Doyle, J., Ge, W., & Mcvay, S. (2007b). Accruals Quality and Internal Control over Financial Reporting. The Accounting Review,82(5), 1141-1170.
Efendi, J., Srivastava, A., & Swanson, E. P. (2007). Why do corporate managers misstate financial statements? The role of option compensation and other factors. Journal of Financial Economics, 85(3), 667-708.
Farber, D. (2005). Restoring trust after fraud: Does corporate governance matter? The Accounting Review, 80(2), 539-561.
Ge, W., & McVay, S. (2005). On the disclosure of material weaknesses in internal control after the Sarbanes-Oxley Act. Working Paper, University of Michigan.
General Accounting Office. (2006). Letter to the Honorable Paul S. Sarbanes regarding the financial statement restatement database. Washington D.C.: GAO-06-1053R.
Grothe, M., Goodwin, J., Iandera, O., Laurion, H., & Freeland, J. (2007a). The materially weak. Yellow Card Trend Alert. Glass Lewis & Co., LLC.
Grothe, M., Saban, J., Plachecki, M., Lee, R., & Post, B. (2007b). The errors of their ways. Yellow Card Trend Alert. Glass Lewis & Co., LLC.
Gong, G., Ke, B., & Yu, Y. (2009). SOX-mandated internal control deficiency disclosure under Section 302 and earnings quality: Evidence from cross-listed firms. Working Paper, Penn State University.
Hammersley, J., Myers, L., & Shakespeare, C. (2008). Market reactions to the disclosure of internal control weaknesses and to the characteristics of those weaknesses under Section 302 of the
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Hoitash, U., Hoitash, R., & Bedard, J. C. (2009). Regulatory intent and political reality: Evidence on corporate governance and internal controls in the post-SOX world. The Accounting Review, 84(3), 811-838.
Kinney, W. R., Palmrose, Z-V., & Scholz, S. (2004). Auditor independence, non-audit services, and restatements: Was the U.S. government right? Journal of Accounting Research, 42(3), 561-588.
Krishnan, J. (2005). Audit committee quality and internal control: An empirical analysis. The Accounting Review, 80(2), 649-675.
Li, C., & Wang, Q. (2006). SOX 404 assessments and financial reporting errors. Working paper, University of Pittsburgh and Iowa State University.
Nagarajan, R., & Carey, P. (2008). Effectiveness of internal control over financial reporting and financial statement restatements: The role of management. Working paper, Monash University Australia.
Palmrose, Z-V., Richardson, V. J., & Scholz, S. (2004). Determinants of markets reactions to restatement announcements. Journal of Accounting and Economics, 37(1), 58-89.
Plumlee, M. A., &Yohn, T. L. (2010). An analysis of the underlying causes attributed to restatements. Accounting Horizons, 24(1), 41-64.
Securities & Exchange Commission. (2003a). Management’s report on internal control over financial reporting and certification of disclosure in exchange act periodic reports. Washington, DC, SEC.
Securities & Exchange Commission. (2003b). Strengthening the commission’s requirements regarding auditor independence. Washington, DC, SEC.
Srinivasan, S. (2005). Consequences of financial reporting failure for outside directors: Evidence from accounting restatements and audit committee members. Journal of Accounting Research, 43(2), 291-334.
Zhang, I. X. (2007). Economic consequences of the Sarbanes-Oxley Act of 2002. Journal of Accounting and Economics, 44(1-2), 74-115.
BIOGRAPHY
Ya-Fang Wang is a full assistant professor of accounting at Providence University. She obtained her PhD degree in 2009—National Chengchi University; Masters in 2003—National Chung Cheng University, and Bachelors in 2001—Providence University. Her research interests and publications encompass financial restatements, internal controls, auditor switches, audit fees and management turnover.
9
HALO EFFECT IN ANALYTICAL PROCEDURE: THE
IMPACT OF CLIENT PROFILE AND INFORMATION
SCOPE
Intiyas Utami, Satya Wacana Christian University Indonesia
Indra Wijaya Kusuma, Universitas Gadjah Mada Indonesia
Gudono, Universitas Gadjah Mada Indonesia
Supriyadi, Universitas Gadjah Mada Indonesia
ABSTRACT
Many auditors use risk-based audit as a methodology that emphasizes assessing audit risk. A holistic perspective during strategic assessment encourages the auditor to focus on the big picture. They understand the industry and client business and determine the risk of material misstatement asan initial hypothesis about the client. Previous research found that a holistic perspective in strategic assessment causes a halo effect. This study focuses on the phenomena of a halo effect in analytical procedures, the impact of a client’s profile and scope of information that be presented to auditor in planning an audit. We propose that auditor judgment is impacted by the client’s profile and professional judgment will be different in a holistic perspective. This study is motivated by bounded rationality of individuals and uses representative heuristics to evaluate clients. The holistic opinion of the person tends to be consistent when analyzing detailed diagnostic information about the person. In an analytical procedure context, understanding of the industry and client business influences the extent to which they adjust account-level risk assessment. We propose two hypotheses. The first hypotheses is that the risk of material misstatement after presentation of client’s profile is positively correlated with the risk of material misstatement after get financial information of client. The second hypothesis is an auditor who obtains information about a client in the scope of holistic information would determine the risk of material misstatement lower than auditor who obtains information in scope of specific information. Data from laboratory experiment using various levels of auditor were collected. The finding suggest a halo effect is generated during analytical procedures and when auditors obtain information about the client in holistic scope.
JEL: M42
KEYWORDS: Halo Effect, Analytical Procedure, Scope of Holistic Information, Specific Scope Information
INTRODUCTION
uditors in a business risk audit approach conducts strategic assessments to develop a holistic perspective of their client’s business model (Bell et al., 2002). Understanding the client’s business and industry is part of the planning step (Arens, Elder and Beasley, 2012) and analytical reviews reveal important insight concerning an auditor’s hypothesis test (Luippold and Kida, 2012). Hypotheses are often developed early in the decision process (Koonce, 1993; Weber et al., 1993). Koonce (1992, 1993) stated that hypothesis testing during analytical procedures as a four-step, diagnostic inference processes: hypothesis generation, and information search and hypothesis evaluation. Bell et al. (1997), Bell et al. (2005) stated that strategic assessment approaches influence auditor expectations. The use of a holistic perspective for strategic assessment is useful in identifying various factors threatening a business model.
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However, evaluative judgment, when assessing performance in detail based on holistic perspective, potentially causes the emergence of a halo effect (Murphy, Jako and Anhalt, 1993). The halo effect is an individual biases in conducting an assessment on a person or object that generalizes assessment of an attribute to conduct an assessment on other attributes (Szhultz and Szhultz, 2010). The halo effect is defined as a “ marked tendency to think of the person in general as rather good or rather inferior and to color the judgments of the person’s specific performance attributes by this general feeling (Thorndike, 1920). The impression of information obtained from one experience significantly effects the next judgment (Tetlock, 1983). Specifically, information items entered earlier are considered more important than later items, this phenomenon is referred to as the halo effect (Grcik, 2008), also called the primacy effect (Hunton, 2001; Hogarth and Einhorn, 1992, Pinsker, 2007; 2008).
The halo effect occurs when knowledge for holistic assessment at the beginning a decision alters the next detailed evidence (Slovic et al., 2002). Studies provide evidence supporting the halo phenomenon in a variety of performance evaluation contexts (Nisbett and Wilson, 1977, Cooper, 1981, Balzer and Slusky, 1992), when information is evaluated using a top-down task structure and when one acquires general information before evaluating detailed performance criteria (Murphy et al. 1993). Moreno et al. (2002) stated the halo effect may affect judgment in accounting contexts and stated that holistic impressions alter investment risk assessments.
The halo effect is in the domain of psychology (e.g Thorndike, 1920; Nisbet and Wilson (1977), education (e.g., Pike, 1999), marketing (e.g Leuthesser et al., 1995, Wirtz and Bateson, 1995). Previous research shows that appearance of an object to be evaluated impacts assessment of another attribute of the object. In an audit setting, the halo effect results in auditors interpreting judgment-specific evidence to be consistent with holistic knowledge. O’ Donnel and Schultz (2005) find the halo effect, associated with strategic risk assessment, influences auditor judgment by altering their tolerance for inconsistent account fluctuation. Grammling et al., (2010) suggests that auditors were influenced by knowledge of a global judgment not directly related to the evidence they evaluated. The factor that influenced the halo effect was object appearance. The convincing object that covers the bad condition triggers the halo effect and influences to less professional judgment. Past research of the halo effect in auditing focuses on a holistic approach and global knowledge to professional judgment. Previous research in analytical procedures can be investigated especially in initial expectations (Messier, Simon and Smith, 2013).
This study differs from prior research because it focuses on the halo effect in analytical procedures that determines initial risk assessment based on visualization of the client profile. Subjects with convincing profiles will evaluate with high rating in another aspects. We propose that subjects with high (low) assessment on convincing client profile presented will assess high (low) misstatement risk of account balance. We specially address an important question related to the halo effect: will the convincing profile client induce less auditor judgment?
Prior research focuses on how the holistic approach generated during strategic assessment influences judgment by altering auditor tolerance for inconsistent fluctuations of account (O’Donnel and Schultz, 2005; Grammling et al. (2010). When auditors conduct analytical procedures within the scope of holistic information, the complexity and ambiguity of the task require nontrivial commitment of cognitive effort and make their judgment quite salient. Luippold and Kida (2012) provide evidence that information ambiguity and data complexity affect judgment accuracy during analytical reviews.
11 This study contributes to behavioral auditing literature in two ways. First, it considers the impact of client profiles in directing auditor perception on material risk of assessment decision. Secondly, this research is expected to shed light on analytical procedures to encourage auditors to scope of client financial report information that influence the auditor’s professional judgment.
We experimentally examine auditor judgment at various levels (junior, senior, manager, supervisor and partner) with regard to the risk of material misstatement on sales accounts in convincing client profiles and in inconsistent fluctuation of accounts. The result suggests that the appearance of a convincing client profile impact on auditor professional judgment, and will determine a low risk of material assessment if client financial information is presented in the scope of holistic.
The remainder of this paper is organized as follows. The next section presents a literature review that includes theory and hypotheses development. The third section provides an experimental research method used in this study, and the fourth explains the results and implications of the study. The conclusion and limitations of the study are presented in the last section
LITERATURE REVIEW
The halo effect is based on cognitive theory. It explains how humans understand, learn, memorize, and thinks about certain information (Stenberg, 2006). In cognitive psychology, mental processes consisting of attention, memorizing, producing and understanding language, problem solving, and decision making will be learned (Riegler and Riegler, 2009).
Bowditch and Buono (2001) stated that individual perception can be the subject of several distortions and illusions that cause individuals to see a different object from its real presentation. The halo effect is a perception distortion process using assessment of a characteristic from an individual or group to cover other characteristic assessments from the individual or group.
An individual who uses judgment for decision making often has a beginning assessment (anchor) on information that is then adjusted when new information is received. This is called the adjustment and anchoring heuristic (Hogarth, 1987). Auditors tendency to weight the last information received is called the recency effect. Tendency to weigh the first information received is called the primacy effect. A theory that explains the primacy effect and recency effect is known as belief adjustment theory developed by Hogarth and Einhorn (1992). They consider an ordering effect to examine interaction between duty characterization and information process strategy. Belief adjustment models consider direction, power, and type of information that by Bayes’ Theorem, explained decision making based on order and pattern of information presentation. The Halo effect, according to Grcic (2008), relates to primacy effect because the impressive anchor assessment is used as the assessment of additional new information. The individual does not revise their belief when additional new information arrives because the impressive anchor still attaches in their memory.
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Analytical procedures are defined as “evaluations of financial information through analysis of plausible relationships among financial and nonfinancial data (AICPA 2012, AU 520). Analytical procedures are required at the planning and review phases of an audit (SAS No. 56, AICPA 1988). Trompeter and Wright (2010) stated that analytical procedures are valuable because auditors consider the reasonableness of financial results based on expectations and with a broader view (forest for the trees as opposed to the tree-by-tree utilized more traditional audit approaches) (Bell et al. 2002; Jacobson, 2001). Analytical procedure is an important phase in the planning step to determine the nature and scope of the audit test.
Auditors develop and evaluate possible explanations when they have identified a misstatement risk associated with an unexpected change in account balance (Yip-Ow and Tan 2000; Asare and Wright, 1997). Auditors use analytical procedures to assess the risk of material misstatement (ISA 315; SAS 107). Auditors use performance measures to highlight situations where problems may exist in management’s strategy that can be a source of audit risk (Kinney and McDaniel, 1996; McDaniel and Kinney, 1995).
Koonce (1992, 1993) presented a cognitive approach based on the four components of a diagnostic, sequential and iterative (DSI) process: mental representation, hypothesis generation, information search and hypothesis evaluation. Messier et al. (2012) stated there are four phases in analytical procedure: (1) develop an expectation, (2) establish a tolerable difference (a difference between the auditor’s expectation and the client’s reported amount that would not warrant further investigation), (3) compare the expectation to the recorded amount and investigate significant differences (differences greater than the tolerable difference), and (4) evaluate explanations and corroborative evidence. Auditor’s performing analytical procedures consider financial and nonfinancial information when formulating mental representations (Blocher and Cooper, 1988; Peters, 1990).
The first researchers to conduct a field study about analytical procedures used by practicing auditors were Hirst and Koonce (1996). They find that most planning work was done by seniors and managers, and auditor’s relied on the client for much of the analytical procedure information. Trompeter and Wright (2010) found that analytical procedures practices had changed to include consultation with non-financial personnel when performing analytical procedures. Another finding are auditors’ development of expectations exhibited better precision. Technology had positively affected expectations and SOX’s focus on internal controls had the potential to lead to more employment of the analytical procedure.
Several behavioral studies conducted on analytical procedures relate to the strategic system approach (SSA) (Bell et al., 1997; Bell et al., 2005) and provide evidence that an SSA approach can influence auditor expectations (Messier et al., 2013). SSA approach can affect auditors’ account risk assessments (O’Donnel and Schultz, 2003; 2005) and using a more thorough strategic assessment can lead to more balance in risk assessment (Knechel, Salterio and Kozlowski, 2010).
The scope of holistic information faced by an auditor when conducting analytical procedures could result in the emergence of a halo effect. Ballou, Earley and Rich (2004), O’Donnel and Schultz (2005) explained that when business risk is determined low, auditor’s became less sensitive to evidence that reflects a potential problem.
13 Professional judgment by an experienced auditor would be better than that by a less experienced auditor (Knapp and Knapp, 2001). The auditor as an information provider tends to seek information that is consistent with his/her judgment. Meanwhile, the partner as a reviewer would tend to seek evidence that is inconsistent (Libby and Trotman, 1993). That condition can be explained by a cognitive model of justification process which is manipulated to seek evidence that supports other decisions or judgments (Peecher, 1996). Auditor’s combine objective justification in mental representation. That decision taken needs support (Gibbins and Newton, 1994). This condition occurs because in audit methodology, the decision making process is gradual, so the previous decision may affect the next decision.
Research in psychology documents that individuals may be subject to “confirmation biases” or “ halo effects (Ballou, Earley and Rich, 2004). Individuals tend to form a hypothesis about a target based on preliminary information and then gather more data about the client by choosing those item of information that will provide evidence to confirm rather than disconfirm their initial hypothesis (Snyder and Swann, 1978; Balzer and Sulsky, 1992; O’Donnel and Schultz, 2005). Halo effect studies primarily focus on the valence of the information and find that a similar confirmatory process occurs (Tan and Jamal, 2001). Research in decision making indicates that individuals tend to confirm their hypotheses and will have a greater response to confirming evidence compared to disconfirming. Church (1990, 1991) and Bedard and Biggs (1991) found that auditor’s exhibited confirmatory tendencies in their evaluation.
A client’s condition that convinces the auditor of a low business risk as well as a good assessment of the internal control system would cause an auditor to determine low risk of material misstatement. Holistic information has formed a mental representation on the auditor about the client who initially is assessed positive. The limitation of the auditor as an individual would tend to conduct an assessment of the next client generally similar to the beginning assessment. By representative bias, general information is used as a comparison on the similarity of general assessment with detailed attributes of financial reports in analytical assignment. In a detailed assessment of accounting, the auditor would use general information that is easily absorbed in memory.
Syneder and Swann (1978) proposed that decision makers generally employ one of three information search strategies: (1) a search for evidence that confirms the hypothesis under scrutiny, (2) search for disconfirming evidence, or (3) a “balanced” search that invests equal amounts of effort to uncover both confirming and disconfirming facts. Auditors that assess the client profile with good condition tend to confirm their initial assessment after get financial information. McMillan and White (1993) found that auditor’s may have a tendency to underweight potentially important error-related evidence when they are not focused on detecting material errors. This may happen because confirmation bias mitigates their sensitivity to material evidence. Based on previous literature and the argumentation, we propose the first hypothesis:
H1: The risk of material misstatement after assessing the convincing client profile should be positively correlated with the risk of material misstatement after obtaining financial information.
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indicates that hypotheses are developed early in the decision process and then used to guide further data gathering (Koonce, 1993). If an auditor fails to assess client risk appropriately, erroneous conclusions may ensue (Fukukawa and Mock, 2011, Bedard and Biggs, 1991).
The level of material misstatement is considered high if an auditor faces a client with high-risk business. Based on findings in previous research in accounting (Earley, 2002), Ballou, Earley and Rich (2004) examines an auditor who views strategic information indicating that a client company is typical (atypical) of others in its industry. The auditor assesses an additional item of evidence indicating a small problem in a business process to be relatively less (more) risky. Phillips (1999) found that an auditor who evaluates evidence related to a low (high) risk account would be less (more) sensitive on detailed evidence of aggressive financial reports. Thus, the executor auditor, when facing general information and obtaining strong impression on client’s condition, would tend to deliver judgment that is consistent with the general assessment when facing detailed transaction assignment. Psychology research has examined differential encoding of typical versus atypical information in memory (Smith and Graesser, 1981; Shapiro and Fox, 2002) affects recall, recognition and processing of additional information (O’Sullivan and Durso, 1984). Based on previous studies, we posit the scope of information may influence the auditor’s professional judgment. The specific scope of information will induce more accurate professional judgment than holistic scope if information.
Brown and Solomon (1990) argued that domain-specific knowledge is crucial for developing expectations for and demonstrating a priori expectations for configure information processing. Both context-and task-specific knowledge need to be used in determining judgment tasks that are more effectively and efficiently accomplished employing information processing (Brown and Solomon, 1991). The determination of business risk is based on the understanding of holistic client information that includes various internal and external aspects. Auditor’s facing holistic information that is convincing on a client would tend to have a high halo bias in determining the level of risk of material misstatement in the analytical procedure. The client considered sound by the partner would make a mental representation that other evidences would be in accordance with the good beginning assessment.
Auditors who conduct strategic assessment at high (low) level would tend to determine the risk of material misstatement to be high (low) (O’Donnel and Schultz, 2005). A positive holistic on a client’s condition in the form of high strategic assessment could cause a high halo effect when facing account fluctuation inconsistency. With a high halo effect, the condition of the client is perceived sound by the auditor, whereas the actual condition is that account fluctuation inconsistency occurs. The client’s condition that is perceived well and is supported by the assessment from the partner that business risk is low causes the risk level of material misstatement in analytical testing to also be determined low.
Specific information that shows a client’s condition in detail indicates the emergence of fluctuation accounting inconsistence could potentially cause a low halo effect. The auditor would be better in grasping the signal of account fluctuation inconsistency in specific information. When facing a partner’s assessment that the level of client’s business risk is determined low, the auditor with specific information does not easily get tricked with the convincing client’s condition. Based on the previous argumentation and research, we can propose the second hypothesis as the following:
H2: Auditor in scope of holistic information would determine the risk of material misstatement lower than auditor in scope of specific information
METHODOLOGY
15 internal validity. An experiment is done by holding audit simulation in an audit seminar. The experiment in general can be described by the matrix in table 1.
Table 1: Matrix of Experiment
Financial Information of Client Before After
Scope of Information
Specific Cell 1 Cell 2
Holistic Cell 3 Cell 4
This table shows the experiment matrix.
Table 1 shows a four cell experimental with the first factor, scope of information, consisting of two levels: specific information and holistic information. The second factor, financial information of the client consists of before and after presentation. Cell 1 is a group with specific information scope before getting financial information. Cell 1 is a group with specific information scope after getting the client financial information. Cell 3 is a group with holistic scope information before getting client financial information. Cell 4 is a group with holistic scope information after getting financial information of the client.
Experimental subjects are auditors (junior, senior, manager and partner) in Surabaya City, Indonesia’s second biggest city, with a large quantity of CPA firms. The design is by completely randomized design done by dividing a two-type audit simulation module to subjects randomly. Therefore, each subject gets the same opportunity to be in the experimental group or control group.
The information is manipulated by two levels, specific and holistic scope of information. The information consist of quantitative and qualitative client conditions with holistic and specific scope, given from partner to auditor. The specific information scope is adapted from Dilla and Stone (1997) and Booker, Drake and Heitger (2007). Participants with specific information were given sales account information in words only, without mentioning any relative comparison. The words that explain the client situation in specific information contain an explanation with the exact condition. This research uses the term holistic information scope as being opposite of specific information. The holistic information presented sales account information in the form of numbers, words and a relative comparison as in Booker, Drake and Heitger (2007). The words that explain the client situation in the holistic information contain explanations with uncertainty conditions. For example, the holistic scope of information stated that the increase of sales in 2012 is 17.76% relative to the previous year. The specific scope of information stated that sales in 2012 had increased.
The risk of material misstatement on the sales account was measured with an analytical test score 1 (very low) to 7 (very high). Participant also determine the risk of material misstatement on cost of goods sold, but for data processing, only the risk of material misstatement on sales account. The determination of risk of material misstatement for cost of goods sold aims to hide manipulation and reduce demand effects. Neuman (2010) explained that demand effects occurred when participants knew the purpose of manipulation given as well as the research objective, so they behaved the same as expected in the research objective.
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The experimental instrument is a convincing client profile for a minimarket distributor company that is presented with a short-duration video (5 minutes). The company illustration differs from the previous research because this research has the additional visualization in the form of pictures and video. The use of visualization gives a positive impression that triggers the halo effect. The minimarket distributor company has a similarity with a big minimarket distributor in Indonesia that has a franchise system. We named the minimarket distributor company Jackomart.
The purpose of the manipulation check is to determine that the manipulation given to subjects can be understood and to help increase internal validity (Neuman, 2010). The manipulation check is comprehensive questions of holistic/specific information scope consisting of three questions. The questions relate to the client’s information given by choice with an alternate answer. The subject is asked to choose the right answers. If the subject answer 2 of 3 questions correctly, she pass the manipulation check, and the data is used.
At the beginning stage, descriptive statistic of the subject’s demographic characteristic are presented. Randomization effectiveness testing based on information scope and mitigation strategy in eliminating individual characteristic differences between groups is done by One Way ANOVA. Halo effect detection on the subject is addressed by questions on the condition of the client including minimarket management, distribution system, and financial performance based on a profile video and booklet of the client’s company. Responses were provided on a 7-point scale, (1=strongly very bad to 7=strongly excellent).
Hypothesis 1 testing is done with Pearson correlation between the risk of misstatement material on sales account 1 (before getting client financial information) and the risk of misstatement material on sales account 2 (after getting client financial information). Hypothesis 2 testing is done by independent t-test that compares average risk of material misstatement on sales account 2 (after getting client financial information) between auditor with holistic scope information and auditor with specific scope information.
RESULTS
The experiment was conducted on February 2nd, 2013 at STIE Perbanas Surabaya City, Indonesia. The subject in this research was junior, senior auditor, manager, supervisor, and partners. They were invited to an International Standard Auditing (ISA) Seminar: Experience and Learning of Auditor’s Error Typology. The invitation was sent on January 8th, 2013 through facsimile, email, and mail to CPA firms in Surabaya City and Malang City, Indonesia. The addresses of CPA firms are based on Directorate of the Indonesian Public Accountant Institute. The number of invitation sent was 51; consisting of 43 for CPA firms Surabaya and 8 for CPA firms in Malang. The total number of CPA firms that registered by February 1st, 2013 was 25. The total auditors who registered was 110 people and those who attended the seminar totaled 72. Each CPA firm sent 2-8 people with position of junior, senior auditors, manager or partner.
The participant received a simulation module consisting of module one for halo effect testing and information scope and module 2 for halo effect mitigation testing. The experimental design included two cases. Each module was entitled and covered the same and had the same number of pages. Randomization was done when the module was distributed randomly to the participant, so each participant got the same opportunity to obtain all audit simulation cases.
17 1 to 2 years old are 32 people; between 4 and 6 years are 11 persons. Most participants (60 people) have education with an accounting undergraduate.
The risk of material misstatement of sales account 2 is determined after subjects receive the manipulation of holistic or specific information scope. ANOVA testing determines that risk of material misstatement on sales account 2 is not affected by the difference of subject demographic characteristic. The testing result by dependent variable was material misstatement risk on sales account 2 and the independent variable was demographic characteristics including sex, age, position, working period, education, participation in public accountant training and audit training as shown in Table 3.
Table 2: Characteristic of Experimental Subject
Information Total (people) Percentage Age
o Accounting Undergraduate 60 92.3
o Non-Accounting Undergraduate 2 3.1
o Accounting Graduate 2 3.1
o Non-Accounting Graduate 1 1.5
This table shows demographic data about the sample.
Table 3: Result of One Way ANOVA test of the Effect of Demographic Characteristic on Risk of Material Misstatement on Sales Account 2
Independent Variable Df F-Statistic Sig
Sex 1 0.154 0.697
Age 5 1.122 0.367
Position 2 0.121 0.886
Working Period 14 0.651 0.803
Education 2 0.658 0.430
Public Accountant Training 1 0.006 0.938
Audit Training 1 0.084 0.773
This table shows the one-way ANOVA analysis results.
18
training and audit training also did not affect the risk misstatement on sales account 2. The probability value of the last education was 0.430, while public accountant training was 0.938 and audit training was 0.773. Therefore, we conclude that risk of material misstatement on sales account was not affected by differences between subject demographic characteristic.
In the experimental test, we must be careful with experimental error, i.e. accounting and auditing capability of subjects. We test that difference of accounting and auditing proficiency score does not affect risk of material misstatement on sales account 2. Testing of experimental error (score of accounting and auditing proficiency) was done with ANCOVA (analysis of covariate) with dependent variable risk of material misstatement on sales account 2. The independent variable is scope of information and covariate variable is score of accounting and auditing proficiency (Table 4).
Table 4: Testing of Experimental Error (Score of Accounting and Auditing Proficiency) on Scope of Information and Risk of Material Misstatement on Sales Account 2
Independen Variable Sum of Square
Score of Accounting and Auditing Proficiency 0.585 1 0.585 0.235 0.630
Error
This table shows the ANCOVA tests results. ** Significant on 5%
Table 4 shows the score of accounting and auditing proficiency is not significant (0.630) and scope of information as a manipulate variable is significant (0.014). The conclusion is risk of material misstatement on sales account 2 will only be affected by scope of information and not by different accounting and auditing proficiency scores or demographic characteristics.
The first hypothesis stated that because the halo forms an impression of client profile, the risk of material misstatement before getting the client financial information should be positively correlated with the risk of material misstatement for the sales account after getting the client financial information. Table 5 shows the result of the Pearson correlation coefficient for halo effects. The strong correlation between risk misstatement on sales account 1 and the risk misstatement on sales account 2 from the result of Pearson Correlation was 0, 349 and significant at 0.004.
Table 5 Pearson Correlation for Halo Effect
Pearson Correlation
Risk of material misstatement on sales 1 (before obtaining information scope)
0.349 P= 0.004** Risk of material misstatement on sales 2 (after
obtaining information scope)
Pearson correlation coefficient for the halo effect. **. Correlation is significant at the 0.01 level (2-tailed).
19 Table 6 shows the results of the second hypothesis testing that was done by comparing the average of sales account 2 risk of material misstatement in the group with specific information scope and the average risk of material misstatement on sales account 2 in the group with holistic information scope. The score pretest in cells with specific information is 4.875 and score of posttest is 4.875. The distribution of specific information scope caused the increasing of sales account material misstatement risk of 0.125. The opposite condition occurred in the group with holistic scope, with pretest and posttest scores of 4.818 and 4.030, shows the difference of risk of material misstatement of sales account -0.788. We compare the difference of risk of material misstatement on sales account 2 and risk of material misstatement on sales account 1 between the cell with holistic scope of information and the cell with specific scope of information. The independent t-test shows that significance of that difference is 0.049. This showed that subjects with a high halo effect and given holistic information scope, still had a high halo effect because they still believed the client’s condition was in accordance with the convincing beginning assessment.
Table 6: Test of Hypothesis 2
Average (Std deviation)
This table shows the results of the Hypothesis 2 tests. a: Average (standard deviation) of material misstatement on sales account 1 (before obtaining information scope) b: Average (standard deviation) of material misstatement on sales account 2 (after obtaining information scope) c: Difference of Misstatement Risk of Sales Account 2 and Misstatement Risk of Sales Account 1 ** Significant at 0,05
The test results show that hypothesis 2 was supported by the data in this research. Auditors who obtained holistic information about the client would determine a lower risk of material misstatement compared to those who obtained specific information. This finding supports the occurrence of a halo effect in the auditor receiving partner information about the condition of a client with holistic or specific information scope. Auditors with a high halo effect and obtaining information from the partner with holistic scope was still impressed by the client’s sound initial assessment, so the attached halo effect would affect the risk assessment of material misstatement of sales account 2 to be similar to the assessment of sales account 1 material misstatement risk. The opposite condition occurred for an auditor with a high halo effect and obtaining information from partner with specific scope. Although it had a positive impression in the initial assessment of the client, it would determine the risk of material misstatement of sales account 2 higher than the risk of sales account 1 material misstatement.
DISCUSSION
20
representative in memory. It was easily memorized when facing an assignment to conduct the risk of material misstatement on detailed account information.
Auditors with client assessment that is positive and impressive, would use the positive impression to conduct positive initial assessments on other assessment attributes before obtaining other information (financial or non-financial) in more detail. A Positive initial assessment on an object effects positive assessment on other attributes from the halo effect.
Information from the partner as part of a client’s business and industry understanding stage could be given in holistic and specific scope. Holistic scope information is overall information containing relative information on client’s condition, while specific information is overall information and does not contain information of account balance comparison. Holistic scope information has potential to result in the emergence of a high halo effect that is marked by decreasing accuracy of auditor professional judgment. Specific scope information has the potential to create a lower halo effect than holistic scope information. This condition impacts the accuracy of auditor professional judgment on auditor specific information scope is better compared to the accuracy of auditor professional judgment on auditor of holistic information.
The result of this research indicates that in professional judgment, the auditor as an individual has cognitive limitations. Initial assessments on a convincing condition of the client is used as a comparison (representativeness heuristic) when conducting assessment on detail information of account balance. The instrument of this research presented information of account balance containing misstatements as part of the partner’s information of holistic/specific scope. Halo effects emerge when the auditor conducting an initial assessment on the condition of the client, after watching video and reading a booklet from client’s company profile, can be seen from a very good initial assessment on the condition management, distribution system and financial performance. This halo effect is brought forward when conducting initial assessments on the risk of material misstatement on sales account 1 and the risk of material misstatement on sales account 2.
This research result confirmed the statement from Hogarth (1987) that a person would remember more the information that reflects more detailed characteristics or information attributes. Holistic scope information may cause auditor professional judgment that is less accurate.
CONCLUSION AND FUTURE RESEARCH
The objective of this study is to examine auditor judgment about the risk of material misstatement on sales accounts in a convincing client profile and in inconsistent fluctuation of account. We use a 2X2 between subjects experimental design to execute the research. The subject in this research was junior, senior auditor, manager, supervisor, and partner that were invited to an International Standard Auditing (ISA) Seminar: Experience and Learning of Auditor’s Error Typology.
21 The previous research that investigated halo effects in of psychology or marketing showed that an individual had limitations in receiving and processing information. In the field of auditing, the halo effect investigated by O’Donnel and Schultz (2005) as well as Grammling et al., (2010) showed the profession demanding high professional skepticism, could not be separated from the halo effect. The previous research has not conducted a test of the means of halo effect mitigation that are reflected in inaccuracy of auditor’s professional judgment.
The result of this research gave description to the auditor that halo effects could occur, especially on less experience auditors. CPA firms needed to anticipate this matter through various training. A novice auditor who usually received an analytical procedure assignment in the planning stage, was more suitable to be given specific scope information rather than holistic scope information.
This study has three limitations. First, the experimental case materials use a positive halo effect. Further research can include a negative halo effect and determine risk of material misstatement. Second, the context of analytical procedures is in the initial hypothesis. Further research is expected to improve the experiment materials in another audit test, in substantive tests or in analytical procedures in the final evaluation phase. Third, this research focus on individual judgment. Future research may examine group decision making.
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